Say ‘this time it’s different’ to experienced business leaders, investors, and analysts, and you’re likely to get laughed out of the room. Carmen Reinhart and Ken Rogoff’s magisterial 2009 book winked at that idea and went on to prove conclusively that, at bottom, all financial crises are identical—or at least close cousins.1 Their thesis: excessive debt, no matter where it’s held, carries more systemic risk than boomtime accounting can adequately reckon with. Sooner or later, the chickens of overleverage come home to roost.
Are today’s economic troubles in the United States any different? No and yes. Start with what’s similar: stocks of US corporate debt have risen dramatically in recent years; indeed, the curve is looking unhealthily parabolic.2 But that doesn’t necessarily mean the country is headed for a financial crisis; corporate cash balances are very high in historical terms.3 And banks’ balance sheets are healthy; equity capital continues near an all-time high.4
What comes next is still uncertain; the only thing we know for sure is that something’s coming. In the event that things go pear shaped in coming months, questions about corporate debt will rapidly come to the fore. What should enterprising US leadership teams do to succeed, and how does the health of their balance sheets set them up for this success? To answer these questions, we looked at 1,200 public companies in the United States and Europe during the Great Recession (2007–11) and the peak of the COVID-19 pandemic (2020–21), looking for results applicable to CEOs and CFOs of US companies and multinational companies with US businesses.
Even Reinhart and Rogoff would likely agree that there are big differences in the financing environments in recent downturns. Interest rates in 2009 and 2022 are about the same, roughly 3 to 4 percent on the ten-year bond issued by the US Department of the Treasury. But in 2020, credit was much looser as governments turned on the spigots of fiscal support (Exhibit 1).
Our research finds that 2020 was an outlier (yes, we’ll say it: that time was different). Credit was so loose during the recovery that financial discipline didn’t pay off for US companies. It’s a different story today. Through October 2022, US “new money” leveraged-loan issuance (in other words, not a refinancing) is down nearly one-third year to date versus 2021.5 A similar measure for high-yield bonds is down nearly 70 percent year-on-year—and 2021 was lower than 2020.
The global financial crisis of the Great Recession is a much closer analogue to today’s environment in this respect. What can the experience of those years teach us today? Our first finding concerns margins and growth. Leading companies improve margins as economies tilt into recession; they also grow faster than peers. But margin improvement is more valuable than growth.
Second, optionality in the balance sheet—a combination of growth in retained earnings and improvement in working capital, on one hand, and a decrease in financial leverage, on the other—is particularly helpful going into and coming out of a period of constrained credit. A third lesson is that an approach that balances growth, margin improvements, and balance sheet optionality helps leading companies outperform those that focus on just one of these dimensions.
Our fourth finding: as conditions improve, deploying balance sheet optionality faster than peers do sets leaders up for success. Building optionality is a means to go big and bold at the right time, not to have the biggest war chest forever.
This article explores the dynamics of operating when capital is constrained. But there’s another important check on business right now: talent. The US labor market continues to run hot; filling jobs isn’t easy. It’s a constraint to be reckoned with, just as much as tight financing. We’ll start by looking back at 2020 to understand why that downturn was different. Then we’ll review the research on the Great Recession and offer some ideas about how US management teams can put the findings to work.
2020 was different
The 2020 downturn differed significantly from both the global financial crisis and the current macroeconomic disturbance in at least one way: credit and financing were much more available in 2020 than in 2008 or 2022. These differences in credit conditions explain why capital discipline (which, as we’ll see, worked so well in 2007–11) didn’t matter very much in 2020.
Through both the global financial crisis and the COVID-19 downturn, both the companies that led in growth and those that led in margin improvement realized outsize returns relative to those that lagged. That is far from surprising and does not provide much direction in today’s environment. More instructive, however, is how companies were rewarded for their balance-sheet management (that is, optionality) in both periods. In the global financial crisis, companies that retained earnings, improved working capital, and eased their debt burden vastly outperformed others (Exhibit 2). In the easier credit markets of 2020, those qualities weren’t rewarded.
Today, 2020 is a distant memory, at least in financial markets. What’s important now is that credit markets are considerably tighter; that is, they resemble those in 2007–11 much more closely than they do those in 2020. Nor is this likely to change soon. Nonetheless, markets anticipate interest rates moving higher in 20236 (the “dot plot” indicates a peak federal-funds rate of more than 5 percent in 2023), as the Federal Reserve Board continues to battle against inflation.
Four management lessons for 2023
Our research indicates that leading US companies in the capital-constrained crisis in 2008–09 succeeded in four ways.
Lesson one: Margin wins—and amplifies growth
Across and within sectors, leaders worked to improve margins early in the global financial crisis, which led to better TSR through the economic cycle. As shown in Exhibit 2, a typical leader (top third) in margin improvement between 2007 and 2009 saw 28 percent more growth in TSR than its peers did. Strong margins help a company ease through macro headwinds; many companies achieve margin strength by improving operating efficiency through upskilling and digital innovation that increases frontline productivity.
In a related finding, across sectors, companies that increased revenues the most early in a recession outperformed peers during both the recessions studied. The typical sector leader saw growth in TSR from 2007–2011 that was 21 percent greater than that of its peers, on average.
So, little surprise: either improving margins or growing revenues can help performance. The key findings are that improving margins early produced bigger gains in performance than early-cycle revenue growth did and that doing both sometimes created a “1 + 1 = 3” effect (Exhibit 3). Leading in revenue growth but lagging behind peers on EBITDA margin performance wasn’t a successful strategy across recessions. Leading on both dimensions produced outsize TSR growth. This isn’t surprising to the seasoned leader, but it’s a departure from the drivers of performance of the past few years.
How did the leading companies do it? Driving sustainable, inclusive growth requires the right mindset, strategy, and capabilities. McKinsey’s extensive research into growth and leadership suggests that growth-oriented leaders think about both the short and the long term. They react decisively to shorter-term disruptions that can be turned into opportunities—what we call “timely jolts”—and build organizational resilience and agility to respond to longer-term change and exploit disruption.
Lesson two: Optionality is especially helpful when credit is constrained
As one economic cycle ends and another begins, doing the little things that can grow retained earnings, improve working capital, and lower the debt burden can lead to outperformance through the cycle. While performance on optionality was not a meaningful differentiator during the 2020 downturn, it demonstrated its importance during the global financial crisis (Exhibit 4).
Building optionality in 2023 is going to be important, just as it was in the relatively tight credit environment of 2007–11. Companies with deep and flexible balance sheets not only have better protection against the risks of economic slowdown but also have reserve funds to pursue the valuable growth opportunities that the recovery phase of a recession brings. As we discuss later in this article, scenario planning can help US companies find opportunities to drive growth, invest in new capabilities that increase productivity, and pursue accretive M&A as the economy begins to rebound.
Lesson three: Growth, margin, and optionality need to be in balance
It’s no surprise that companies that excelled (top 20 percent) on all three dimensions—growth, margin, and optionality—in the downturns studied outperformed their peers on average. What we also find, however, is that balanced performance across all three delivered better returns than spiky performance on one dimension alone did. Companies that were in the top 20 to 40 percent on all three dimensions outperformed those that excelled on only one dimension and fell into the bottom 60 percent on others.
Lesson four: Use the options at the right time
Companies that built optionality early in the 2008–09 cycle made more value-accretive moves than their peers did as the cycle progressed. In a capital-constrained environment, building optionality early on provides companies with an influx of cash to fund growth as the economy pivots to recovery.
Leaders (top third) in early-cycle optionality across sectors in effect built up a war chest early in the cycle that they then spent on value accretion during the rebound phase of the recession cycle (Exhibit 5). Prior McKinsey research found that outperformers were more acquisitive than others. Now we know why, and how, they did it. They used the strength of their balance sheets for accretive M&A, and they also invested into the business, often in marketing and R&D.
Theory into practice
The tasks of improving margins, building optionality, and achieving growth are a kind of virtuous circle. Boosting margins allows companies to sock away more capital; the resulting optionality can fuel a burst of growth. Here we focus on optionality; many actions can help companies retain more earnings, improve working capital, and deleverage; their complexity varies.
The choice of actions depends on a company’s risk profile and industry. For instance, retailers can take steps to improve inventory management, manufacturers can improve their payment processes, and technology companies can look for ways to monetize intellectual property—as can many nontech companies. As we have published previously, even though many companies rightly focus on profit and loss, there are many ways to build resilience and create value on the balance sheet in parallel.
Once stores of optionality are built, the question then becomes what to do with them—and when. Across all our findings, it’s clear that moving early in the recovery cycle brings outsize rewards. But there’s a fine line between too early and just right; it’s hard to time an economic rebound.
Timing will also vary by industry. Some, such as retail, have short investment horizons, and some, such as semiconductors, have much longer runways. Timing can vary even within an industry. In oil and gas, for example, fracking rigs can be installed and operational within a few months, while offshore platforms take years.
Scenario planning can help companies identify trigger points that signal a pivot to value accretion. When those trigger points are reached, companies have a better idea about when to make an acquisition or other strategic moves, such as adding staff, investing in R&D, and making smart capital investments in the core business. Leaders should bear in mind that waiting for clear evidence of a turnaround may mean missing valuable opportunities to acquire or invest.
